Question: Municipal Bonds, Part 2

Answer:

Two weeks ago in this column we discussed the basics about municipal bonds, how they differ from corporate bonds and the advantages of adding them to your portfolio. Click HERE to read. Today, we'll review the different types of munis that are currently available.

While municipal bonds are not offered through BUYandHOLD, you can trade them through our full-service affiliated site Freedom Investments.

Types of Municipal Bonds

• General Obligation Bonds (GOs). Also known as public purpose bonds, these are sold to finance roads, schools and government buildings. They are the most conservative of the municipals and are backed by the full taxing power of the state or local government that issues them. The interest and principal are paid to bondholders out of a government's general revenue -- primarily its taxes.
  
  
• Revenue Bonds. These are issued to finance public works projects. Their interest and principal are paid to bondholders only from the revenues generated by the project that the bonds were issued to build -- an airport, highway, tunnel, toll bridge or sewer treatment plant, for example. Because of this limited source of income, they are generally regarded as slightly less safe than GOs.
  
  
• Taxable Municipals. For many years, all municipal bonds were tax free, but that's no longer the case. Bonds issued to finance private business activities and ventures, such as shopping malls, sports stadiums, convention and trade shows, industrial parks and parking facilities, are often exempt from state and local taxes where issued, but subject to federal income taxes.
  
  These taxable municipals or private activity bonds as they're also called, generally yield slightly less than fully tax-exempt municipals.
  
  Note: Income from certain kinds of private activity bonds, however, is still fully tax exempt -- those issued to build a hospital, for example.
  
  Caution: A heads up for investors in high tax brackets who have a sizable amount of tax sheltered income: Interest received from taxable municipals issued after August 7, 1986 may be subject to the alternative minimum tax (AMT). The AMT taxes so-called preference income above a certain level at a flat rate. Check with your accountant.

• Zero Coupon Municipals. These bonds provide no interest income to the owner until they mature. Instead, they are sold at a discount (below par) and you receive the full face value at maturity. Because they are sold far below face value, zero coupon munis are an inexpensive way for small investors to participate in the municipal bond market.
  
  If, for example, you buy a zero at $800, when it matures you'll receive the full face value of $1,000, but there will be no federal income tax due on the $200 profit made during the holding period.
  
  $Tip: Zero coupon bonds are an excellent way to pay for college or set money aside for retirement or other distant goals.
  
  
• Pre-refunded Municipals. Sometimes a municipality floats a new bond issue when interest rates have dropped in order to save money. They then pay off the first bond which has a higher interest rate. The proceeds from the sale of the second bond are invested in U.S. Treasuries that in turn are held in escrow until the old bonds can be redeemed.
  
  Because the money to repay the bonds is set aside and invested in Treasuries, these bonds are considered very safe.
  
  
• Single State Bonds. If you live in a high-tax state, look for munis issued by your own state and, if possible, by your local government. By avoiding state and local taxes, you can improve your after-tax return. Among the highest taxed states are California, Massachusetts, Minnesota and New York.

Stay tuned...next week we'll discuss: (a) how bonds are rated, (b) the advantages and disadvantages of insured bonds and (c) why Puerto Rican municipals are so special.